Lesson From The Tax Court: How To Tell When Land Is Held As A Capital Asset

When a taxpayer buys land and later sells it, the character of the resulting gain or loss will depend on whether taxpayer held the land as an investment or instead held it like inventory, to be sold to customers as part of a trade or business.  It is not always easy to tell how the land is being held and courts look at a variety of factors.

The lesson I take from William E. Musselwhite Jr. and Melissa Musselwhite v. Commissioner, T.C. Memo. 2022-57 (June 8, 2022) (Judge Ashford), is that how the taxpayer self-reports the activity in years prior to the year of disposition is one important factor in determining when land is held as investment.  There, Mr. Musselwhite acquired four lots in what was to become a residential development.  No development happened.  For years he consistently reported holding the lots for investment.  But when he eventually sold them for a big loss he and his wife reported the loss as ordinary, claiming on that return that he held the land for development.  In an informative opinion, Judge Ashford held Mr. Musselwhite to his prior reporting position.  Details below the fold.

Law: Land As Capital Asset
My students quickly learn why taxpayers want their gains to be capital and their losses to be ordinary.  Congress taxes long-term capital gains much less than ordinary gains.  §1(h).  At the same time, however, Congress prohibits taxpayers from using long-term capital losses to offset that higher-taxed ordinary gain.  §1211.  So the game is to frame losses as ordinary and gains as capital.  That can be especially tricky in times of volatile economic conditions such as the Great Recession and, just perhaps, now.

A long term capital gain or loss is generated when a taxpayer sells or exchanges a capital asset held for more than one year.  §1222(3), (4).  I emphasize to my students that what is being sold or exchanged must be a capital asset and not something else.  Section 1221(a) tells us that a capital asset is generally “property held by the taxpayer (whether or not connected with his trade or business).”  But then §1221(a) provides a long list of exceptions to that general rule.  One of the key exceptions is that the inventory of a business—or property that is like inventory—cannot qualify as a capital asset.  Specifically, §1221(a)(1) says that a capital asset cannot be “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer...or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” The Supreme Court has explained the purpose of section 1221(a)(1) “is to differentiate between the profits and losses arising from the everyday operation of a business on the one hand and the realization of appreciation in value accrued over a substantial period of time on the other.” Malat v. Riddell, 383 U.S. 569, 572 (1966).

Thus, if a taxpayer holds land as an investment, then the land will be a capital asset.  But if the taxpayer is holding land primarily to sell to various customers, well that makes it look like inventory and the land won’t be a capital asset.

Whether land is held as investment or inventory is a facts-and-circumstances determination.  As the 10th Circuit put in in the classic case of Mauldin v. Commissioner, 195 F.2d 714, 716 (1952): “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts.”  And when you read the cases you see various courts giving various formulations of which facts matter and why.  Here, Judge Ashford adopts the following formulation of important factors used by the 4th Circuit, because that is where any appeal would go:

“(1) the purpose for which the property was acquired; (2) the purpose for which the property was held; (3) improvements, and their extent, made to the property by the taxpayer; (4) the frequency, number, and continuity of sales; (5) the extent and substantiality of the transaction; (6) the nature and extent of the taxpayer’s business; (7) the extent of advertising or lack thereof; and (8) the listing of the property for sale directly or through a broker.” Op. at 11.

Further, as Judge Ashford notes, “no one factor or group of factors is determinative, and not all factors may be relevant in a particular case.....  Op. at 11 (citations omitted).

With this intro in mind, let’s look at the relevant facts and circumstances of this case.

Facts
Mr. W. Edward “Eddie” Musselwhite has been a personal injury lawyer in Lumberton, N.C. since graduating from law school in 1981.  He has also been both a real estate investor and real estate developer.  For example, in 1986 he (with others) purchased 100 acres of undeveloped land, divided it into 90 lots, and developed them into Wycliffe East in Lumberton and sold them over a 13 year period.  During that time he also developed another Lumberton subdivision.

In 2005 Mr. Musselwhite expanded his real estate activities into Brunswick County, N.C., about 80 miles away, just south of Wilmington.  According to both its Wikipedia entry and this population tracking website Brunswick County’s population had grown from about 50,000 in 1990 to over 73,000 in 2000 and was continuing to grow rapidly.  So I am sure it seemed like a good bet at the time.  Here, Mr. Musselwhite took a different approach than he had in Lumberton.

To conduct his Brunswick County real estate activity, Mr. Musselwhite formed a 2-person LLC with a fellow Lumberton real estate developer David Stephenson and, using their initials, called it “DS & EM Investments.”  I’ll just call it “the LLC.”

In 2005 the LLC bought various properties for investment, including five condos, some undeveloped lots, and an expensive house in Wilmington.

In August 2006 the LLC did a deal with yet another North Carolina real estate development, Mr. Lisk.  I don’t know much about real estate developers, but this just seemed like a Crazy Deal.  Mr. Lisk apparently wanted the expensive house in Wilmington and offered to buy it for $2 million, but only if the LLC would in return pay $1 million for four of nine undeveloped lots that Mr. List owned and was in the process of developing.  To sweeten the deal, “Mr. Lisk agreed to give [the LLC] a one-year personal guarantee that the four lots it was purchasing would sell within one year and that it would net $1 million from such a sale or he would buy back the remaining unsold lots.” Op. at 4.  Crazy?  So that’s how the LLC ended up buying the four lots for $1 million, financing the purchase with a $750,000 loan.  And of course all of this was going to work out great once Mr. Lisk developed all nine lots and sold them for oodles of money.

Well, the deal fell apart faster than you can say “Great Recession.”  Mr. Lisk conducted some development activities on the lots, but none sold within the year.  The LLC sued Mr. Lisk to enforce his promise.  In December 2008 the parties settled the lawsuit by having Mr. Lisk transfer his other five lots to the LLC.  So now instead of owning four increasingly worthless lots, the LLC owned nine.

But hope springs eternal.  Between December 2008 and September 2011 the LLC stuck “for sale” signs on the lots and waited for them to sell.  Op. at 6.  At no time, however, did the LLC engage in any acts of development beyond what Mr. Lisk had done prior to the transfer, even after removing the for sale signs in September, shortly after the bank holding the loan appraised the lots at $23,500 and started to make unhappy gurgling noises.

In June 2012, the bank appraised the four lots at $17,500, stepping up the pressure.  The LLC partners were scrambling to manage their personal financial affairs and decided to have the LLC make partial distributions to each of them.  In July 2012, as part of that adjustment, the LLC distributed to Mr. Musselwhite the original four lots it had purchased.  Op. at 6.  The opinion does not say what happened to the other five lots.  Mr. Musselwhite redoubled efforts to sell the four lots and in November 2012 unloaded them for $17,500, resulting in a loss just over $1 million.

In April 2012, the LLC filed its 2011 Form 1065 and for the first time reported it held the four lots of land as inventory.  Despite that change, “no Schedule C relating to Mr. Musselwhite’s real estate activities was attached to” Mr. Musselwhite’s individual Form 1040 for 2011.  Op. at 9.  Only on his 2012 return did Mr. Musselwhite submit a Schedule C reporting a real estate development activity.  And that was to report the $1 million as an ordinary loss, using it to offset almost $1.2 million in ordinary income from his law practice.

On audit, the IRS said “whoa, that there’s a capital loss, son.”  It issued its NOD in March 2016, trial was held December 2017, and post-trial briefing was completed in April 2018.  Four years later we get our Lesson From The Tax Court.

Lesson: Long-Time Reporting Position Factors Into Capital Asset Determination
I think the case is mostly decided on the 4th Circuit’s first two factors: the purpose of the initial purchase and subsequent holding treatment.  As Judge Ashford is careful to note, “objective factors carry more weight than the taxpayer’s subjective statements of intent.”  Op. at 11 (citations omitted).  And the biggest objective fact here is how the LLC consistently reported its activities to various governmental authorities.

First, on its 2006-2012 Annual Reports to the State of North Carolina, the LLC consistently represented that its business was real estate investment.  Second, on its 2005-2010 federal income tax returns, the LLC consistently reported its principal business activity as “Investment” and reported (on Schedule L) that it had no inventories.  Instead the Schedule L reported the assets of the LLC as “other investments.”  Op. at 8.  Finally, these federal returns reported no gross receipts or sales but did report various capital gains and capital losses.

As against this, Mr. Musselwhite seems to have made two arguments.  First, his attorney tossed his long-time CPA (a Mr. Edwards) on the stand to testify that when preparing the 2012 return reporting the lots as inventory, “it was his professional judgment that the lots were always held as inventory.”  Op. at 8.  Apparently, despite being Mr. Musselwhite's long-time CPA, that was the first time Mr. Edwards had seen the Crazy Deal paperwork.

Judge Ashford was not impressed.  She notes that while Mr. Edwards talked the talk at trial, he had not walked the walk before trial: “Mr. Edwards did not file amended Forms 1065 for DS & EM Investments as to the prior taxable years reporting the lots’ purported status as inventory.”  Op. at 8.  Additionally, she notes that the record was not clear whether Mr. Edwards ever consulted with Mr. Musselwhite.  That would be important because “Mr. Musselwhite testified that all the things he and Mr. Stephenson were doing through [the LLC] were ‘really investment’ and that specifically with respect to [the LLC’s] acquisition of the four lots, it was an opportunity to invest in a subdivision that Mr. Lisk (who was an established developer) was already developing (as the owner of the other five lots in the subdivision).” Op. at 12.  Hmmm.  So maybe it was not the greatest move to have the taxpayer testify?

Mr. Musselwhite’s second argument appears to be that even though the property was initially purchased for investment, that purpose changed once the LLC got ownership of all the parcels in 2008.  Or maybe once the lots were transferred out of the LLC to him.  It’s not clear.

Judge Ashford agreed that one can certainly change how one is holding property.  Op. at 13.  But here, “the only improvements to the four lots were made by Mr. Lisk.”  Op. at 13. After the 2008 transfer, no improvements were made to the lots, either by the LLC, which continued to hold the lots until 2012, nor by Mr. Musselwhite, during the three months he held the lots after the LLC’s distribution to him.  Op. at 14.

And, again, during almost all this time, the LLC reported holding the land as investment.  When it did change its reporting, it was not to reflect any change in use so much as to give cover to Mr. Musselwhite’s Form 1040 reporting position. Judge Ashford spells it out for us:

“when [the LLC] distributed the lots to him, he had no intention of developing them, and by April 29, 2012, the date on which [the LLC’s] Form 1065 was filed, he...knew that the fair market values of the lots were less than [the LLC’s] bases in the lots.  Incredibly, the 2011 Form 1065 was the first such form...on which the lots were classified as being held as inventories. To be sure, Mr. Musselwhite was continuing to experience financial problems in 2012, but such reclassification provided no incentive for him to hold on to the four lots and develop them; the reclassification was his purported “ticket” to getting a significant ordinary loss through a quick sale of the lots.”

Bottom Line: The indeterminate multi-factor test for determining whether land is a capital asset gives taxpayers a lot of wiggle room on their choice of how to report their activity.  Because of that, and because our system depends heavily on taxpayers’ self-reporting, it is appropriate for courts to be skeptical of a single year switch in reporting that contradicts the reporting position of multiple prior years.  Multi-year reporting positions is a factor one should always consider whether trying to determine whether land is a capital asset.

Coda:  This case pairs nicely with Sugar Land Ranch Dev., LLC v. Commissioner, T.C. Memo. 2018-21, which I blogged about in Lesson From The Tax Court: The Tax Lawyer’s Wedding Toast, TaxProf Blog, (Mar. 5, 2018).  There, the taxpayers did the opposite of Mr. Musselwhite.  They started as developers but transformed into investors.  Like Mr. Musselwhite, they wanted to change how they held the land for tax reasons: they eventually sold the properties for a net gain in 2012. So they wanted the rate subsidy for capital gains.  They got it because they were able to demonstrate through objective evidence—a contemporaneous Unanimous Consent—that they had abandoned any development plans in favor of holding the land until the real estate market recovered enough to sell at a profit.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each week to TaxProf Blog for another Lesson From The Tax Court.